Credit Opinion: EEPK Global Credit Research - 08 Jan 2015 Luxembourg Ratings Category Moody's Rating Outlook Stable Bank Financial Strength E Baseline Credit Assessment caa2 Adjusted Baseline Credit Assessment ba2 Issuer Rating -Dom Curr Ba2 Parent: Commerzbank AG Outlook Bank Deposits Negative(m) Baa1/P-2 Bank Financial Strength Baseline Credit Assessment D+ ba1 Adjusted Baseline Credit Assessment ba1 Issuer Rating Senior Unsecured Baa1 Baa1 Subordinate Commercial Paper -Dom Curr Ba2 P-2 Other Short Term (P)P-2 Contacts Analyst Phone Mathias Kuelpmann/Frankfurt am 49.69.707.30.700 Main Michael Rohr/Frankfurt am Main Carola Schuler/Frankfurt am Main Maximilian Denkmann/Frankfurt am Main Key Indicators EEPK (Consolidated Financials)[1] [2]6-14 [2]12-13 [2]12-12 [2]12-11 Avg. Total Assets (EUR million) 16,725.4 16,680.9 20,470.7 24,502.2 [3]-12.0 Total Assets (USD million) 22,899.6 22,985.4 26,988.5 31,807.5 [3]-10.4 Tangible Common Equity (EUR million) 408.5 403.4 458.4 488.5 [3]-5.8 Tangible Common Equity (USD million) 559.3 555.8 604.4 634.1 [3]-4.1 Net Interest Margin (%) 0.2 0.3 0.3 0.2 [4]0.2 PPI / Average RWA (%) -- -1.6-1.3-8.3 [5]-3.7 Net Income / Average RWA (%) -- -1.6-0.9-7.1 [5]-3.2 (Market Funds - Liquid Assets) / Total Assets (%) 82.9 79.6 78.9 74.4 [4]78.9 Core Deposits / Average Gross Loans (%) -- 10.2 10.8 10.1 [4]10.4 Tier 1 Ratio (%) -- 10.6 13.5 14.4 [5]12.8 Tangible Common Equity / RWA (%) -- 11.3 13.9 14.6 [5]13.3 Cost / Income Ratio (%) 22.0-16.9-21.4-2.7 [4]-4.8 Source: Moody's
[1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel II; IFRS [3] Compound Annual Growth Rate based on IFRS reporting periods [4] IFRS reporting periods have been used for average calculation [5] Basel II & IFRS reporting periods have been used for average calculation Opinion SUMMARY RATING RATIONALE We assign a long-term issuer rating of Ba2 (stable outlook) to Erste Europaeische Pfandbrief- und Kommunalkreditbank Aktiengesellschaft in Luxemburg S.A. (EEPK). The rating is based on (1) its caa2 baseline credit assessment (BCA); and (2) our assessment that the probability of support from its parent bank Commerzbank AG (deposits Baa1 negative; bank financial strength rating (BFSR) D+/BCA ba1 stable) remains very high throughout the unwinding of existing business. Under our joint default analysis (JDA) methodology, our support assessment gives EEPK's Ba2 issuer rating a six-notch uplift from its caa2 BCA. As a foreign subsidiary of Commerzbank, EEPK's long-term rating does not incorporate any systemic support from the German government (Aaa stable). Our assumption of a very high probability of parental support for EEPK remains underpinned by (1) a Letter of Comfort (LoC) from Commerzbank; and (2) substantial levels of intra-group funding. Given the funding with `Lettres de Gage' (covered bonds) we consider Commerzbank to continue to be committed to wind down the bank in an orderly fashion as otherwise we would expect spill-over effects to materialise for Commerzbank's franchise in the German covered bond market. EEPK's standalone E bank financial strength rating (BFSR), which is equivalent to a caa2 BCA, remains constrained by (1) the bank's franchise impairment; (2) Commerzbank's decision to unwind EEPK's entire business in the context of challenging market conditions for its divestment (which was required by the European Commission); and (3) some residual tail risk with regard to the bank's moderate asset quality related to its exposures to local authorities in the US, and regional creditors in Italy and Spain. These constraints are only partly offset by recently improved capitalisation as a result of the merger of Hypothekenbank Frankfurt International S.A. (HFI, unrated) and the previous EEPK entity. Rating Drivers - EEPK's franchise is limited by its status as a wind-down entity - Moderate asset quality, with tail risks in the public finance portfolio - High leverage is a rating constraint - Weak profitability as a result of EEPK's status as wind-down entity - Modest liquidity risk owing to funding support from Commerzbank Rating Outlook The outlook on EEPK's issuer rating is stable, in line with the stable outlook on Commerzbank's BFSR. EEPK's standalone E BFSR does not carry an outlook. What Could Change the Rating - Up Upward pressure on EEPK's rating could develop on the back of a strengthening of its creditworthiness, following a possible orderly wind-down and a further strengthening of its capital base. EEPK's ratings would also benefit from improvements in Commerzbank's fundamental credit strength; i.e., if we were to adjust Commerzbank's BCA upwards, positive pressure would develop on the uplift and hence EEPK's issuer rating. What Could Change the Rating - Down The support from Commerzbank incorporated into the rating is key for EEPK's issuer rating. If Commerzbank were no longer committed to the orderly unwinding of EEPK and opted to withdraw the LoC, EEPK's rating could face a multiple notch downgrade as a result of a review of the support uplift factored into EEPK's ratings. Further pressure would likely develop for EEPK's rating in the event of a significant worsening of the credit quality
for the more critical parts of its exposures (exposures to local authorities in the US, and regional creditors in Italy and Spain). DETAILED RATING CONSIDERATIONS EEPK'S FRANCHISE IS LIMITED BY ITS STATUS AS A WIND-DOWN ENTITY Since 1 September 2014 EEPK comprises the merged businesses of two Luxembourg-based Commerzbank subsidiaries: previous EEPK, which holds a portfolio of public-sector loans, and previous Hypothekenbank Frankfurt International S.A. (HFI, unrated), a wind-down entity that used to be a subsidiary of Hypothekenbank Frankfurt (HF, deposits Baa3 negative; BFSR E/BCA caa2) and contained HF's international public finance portfolio in Luxembourg. Both entities use "Lettres de Gage"(covered bonds) to refinance a portfolio of publicsector loans. End of June 2012, HFI was put into wind-down together with HF (collectively former Eurohypo) as part of Commerzbank's state-aid ruling. On 1 September 2014, previous EEPK was merged onto HFI which was then renamed into EEPK. MODERATE ASSET QUALITY, WITH TAIL RISKS IN THE PUBLIC FINANCE PORTFOLIO EEPK's asset quality is moderate and contains considerable concentrations to public sector creditors in the US (Aaa stable), the UK (Aa1 stable), Italy (Baa2 stable), and Spain (Baa2 positive). At year end 2013, EUR2.3 billion exposures of former HFI were accounted for as non-investment grade risk. As of December 2013, the public-finance portfolios of former HFI and former EEPK accounted for exposures of EUR12.7 billion and EUR4.5 billion, respectively. The combined portfolio mainly comprised exposures to public sector entities in the US (EUR4.8 billion), the UK (EUR2.2 billion), Spain (EUR1.9 billion) and Italy (EUR1.8 billion). As part of this exposure, HFI had some exposure to US student loans (EUR2.7 billion) and LoBo-loans (EUR2.2 billion). LoBo loans (LoBo = Lenders Option /Borrowers Option) are long dating loans to local authorities in the UK which allow for discretionary interest rate increases by the lender which the borrower can accept or repay the loan. The 50 top LoBos account for EUR1.8 billion and therefore represent a comparatively concentrated exposure. HFI, prior to its merger with EEPK, had a negative difference of book values to market values of EUR755 million as of June 2014. HIGH LEVERAGE IS A RATING CONSTRAINT The bank's pro forma common equity tier 1 (CET1) capitalisation of 16.8% as of 1 September 2014 increased from 9.1% at former HFI as a result of the merger. The bank benefits from a 0% risk-weight for public-sector exposures in the European Economic Area for former HFI. EEPK's substantial leverage at 2.86% (equity as % of total assets) on the back of EUR676 million equity is a further rating constraint. WEAK PROFITABILITY AS A RESULT OF HF'S STATUS AS WIND-DOWN ENTITY For the first half year 2014, former HFI reported a pre-tax profit of EUR10.8 million (H1 2013 pre-tax loss of EUR62.0 million). Former EEPK reported a EUR5.2 million pre-tax profit (H1 2013 pre-tax loss of EUR11.8 million). On a pro forma basis, EEPK reported a EUR26.8 million pre-tax profit for the eight months to August 2014. We expect profitability to remain weak during the next few years, albeit partly because the bank may decide to take losses actively by selling assets below par in order to accelerate the unwinding process. We expect less pressure both from further write-downs on EEPK's exposures or from additional provisioning needs, to the extent that EEPK's exposures continue to benefit from the economic recovery in Europe. MODEST LIQUIDITY RISK OWING TO LIQUIDITY SUPPORT FROM COMMERZBANK The bank is funded by `Lettres de Gage' and it obtains senior funding mainly from Commerzbank group (EUR7.1 billion at year-end 2013 for former HFI). The bank remains closely integrated into Commerzbank's group treasury, and benefits from Commerzbank's funding costs, as group funds are passed through on favourable terms. Global Local Currency Deposit Rating (Joint Default Analysis) EEPK's Ba2 issuer rating takes into account its weak caa2 BCA and our assessment of a very high probability of support from Commerzbank. Moody's joint default analysis (JDA) uses Commerzbank's BCA of ba1 because EEPK does not receive any systemic support from the German government. The rating is placed one notch below
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